Friday, June 3, 2016

Accounting - Limited brands Case solution [An Annual Report and FSA]

Limited Brands, Inc.

Using the 2010 10k for Limited and the Chicos extracts provided below, answer the following questions.  Be sure to provide well written answers that are clearly supported.

1.         Are the Limited and Chicos in the same business? – compare and contrast.  Will the differences affect our financial comparisons that follow?  Do you think we can avoid such problems?

Both Limited and Chico’s are in the fashion retail business. They both operate retail stores and own a number of brands within the fashion segment.

Limited is heavily dependent on lingerie (Victoria’s Secret).  Their fashion focus is on younger women.  They also are involved in beauty products through Bath & Body works.  Limited’s Apparel business (Limited & Express) was not a great contributor to the recent success of the firm and they divested most of their investment in the last three years. Chico’s focus on older women (Chico’s & WHBM), just entered the lingerie business (Soma) a few years ago and is not involved in the beauty product business.

To the extent that the Lingerie business and beauty product business differs from female fashions, then yes it makes our comparisons more difficult.  For example, if Lingerie sells at higher margins, then comparing margins becomes problematic.  Unfortunately, it is rare to find companies that are exactly comparable.

2.                  Calculate ROE for Limited and Chicos for the 3 years on the I/S.

Limited (in millions)
2010
2009
2008
Net Income
        $805
        $448
            $216
Average SHE
      $1,831
     $2,030
         $2,075
ROE
44.0%
22.1%
10.4%

Chico's (in millions)
2010
2009
2008
Net Income
        115
        70
            (19)
Average SHE
        1,024
        942
            908
ROE
11.2%
7.4%
-2.1%


3.                  Are there any changes (Re: Question 2) over the years? Which firm is performing better for their shareholders?

Limited has quadrupled its ROE from 2008 to 2010. They achieved this by both increasing Net Income and decreasing SHE by returning money to its investors via stock repurchases and dividends. Chico’s improved their performance as well, from a loss in 2008 to 11.2% positive ROE in 2010, but this performance pales in comparison to Limited’s 44% ROE in 2010.  Chico’s also paid a large dividend and repurchased shares in 2010, reducing SHE, but Chico’s has no long-term debt. Their long-term obligations are all deferred rent and lease credits. 

Shareholder’s equity represents investments made by shareholders as well as profits retained by the firm. (Note these amounts may be based on events that transpired well in the past.)   Shareholders have a claim on net income – so ROE is a measure on return on investment for shareholders.  From an accounting perspective, Limited is performing better for their shareholders.  Stock returns may be a different story.

4.      Compare GM % and SG&A% for the period for each firm. Which appears to be managing costs better?

In 2009 and 2010, Chico’s gross margin percentage (GM/Sales %) improved to 56% from 51.8% in 2008. They have also reduced their SG&A expenses (from a high of 54.3% of Sales in 2008 to 46.8% of Sales in 2010). 

In comparison, Limited’s GM% ranged from 33.2% in 2008 to 37.8% in 2010.  Limited has a much lower percentage of SG&A expenses relative to Sales which slightly decreased from 25.1% to 24.4%.

Notice Net: GM less SG&A – Chico’s is about 9% and Limited is 13% - which seems to support our intuition that Limited faces less direct competition and hence might be more profitable.  The fact that Chico’s has a higher GM% seems odd – given our understanding of Limited’s market position.

Further investigation shows that each company describes their CoGs line on the income statement differently – Chico’s only has CoGs, Limited shows CoGs, buying and occupancy.  This suggests that perhaps different presentation explains the odd comparisons that we obtain.

By including additional costs with CoGs, Limited depresses their GM.  Chico’s appears to include these additional costs in SG&A – explaining some portion of their relatively higher SG&A.

5.         Decompose the 2010 ROE using the Dupont analysis framework and compare the components across the two companies.  Discuss the results.
dupont
Use average assets and average shareholder’s equity


Chico's
Limited

2010
2009
2008
2010
2009
2008
Net Income
115
70
-19
805
448
216
Sales
1,905
1,713
1,582
9,613
8,632
9,043
Total Assets
1,416
1,319
1,226
6,451
7,173
6,972
SHE
1,065
982
902
1,477
2,184
1,875
Avg Assets
1,367.5
1,272.5
1,238
6,812
7,072.5
7,204.5
Avg SHE
1,023.5
942
907.5
1,830.5
2,029.5
2,075
NI/Sales
0.060
0.041
-0.012
0.084
0.052
0.024
Sales/Assets
1.393
1.346
1.278
1.411
1.221
1.255
Assets/SHE
1.336
1.351
1.364
3.721
3.485
3.472
ROE
11.24%
7.43%
-2.09%
43.98%
22.07%
10.4%

Limited has a higher profit margin every year and both companies have an upward trend. Chico’s, however, had a better asset turnover (shown by the Sales/Asset ratios) in 2008 and 2009 and an upward trend for the whole period. Limited improved their asset turnover to exceed Chico’s in 2010 after a decline from ’08 to ’09. The leverage across the two companies is significantly different, as well. Limited has increased their leverage in 2010 after a slight reduction in 2009 while Chico’s has steadily reduced their leverage each year. The Limited’s higher leverage is beneficial to their shareholders but comes with an increase in risk, since debt requires fixed payments.

Limited’s ROE in 2010 is almost 4 times that of Chico’s with a leverage that is 2.8 times higher.  So, while Chico’s has managed to recover and improve from their loss of 2008 and has significantly lower leverage and less risk, Limited has performed significantly better during this period.

6.Note 21 presents the Limited’s segment data.  Evaluate the segment’s relative performance? Justify and explain your approach.


VS
BBW
Other
Oper. Inc.
887
464
-57
Total Assets
2,849
1,330
2,272
ROA
31.1%
34.9%
-2.5%

Bath & Body Works is the best performing segment but Victoria’s Secret is not far behind based on return on assets.

Other consists of some small specialty stores, Limited’s international retail, franchise, and wholesale operations (including VS and BBW Canada) and corporate overhead.  Notice the large amount of assets in “Other” (all of the business must make up for this large investment in Corporate assets). 

Notice, we don’t have NI by segment, only Operating Income, so we ignore some overall corporate expenses that are not included, like interest and taxes in calculating ROA.

Assets need to financed, which bears an implicit or explicit cost.  The success of those assets can be evaluated based on return on assets.  Assuming the risk of investing in VS or BBW is the same – if one had to choose – clearly one should maximize expected return or ROA – in this case BBW.

7.      Which Audit firm is the auditor of Limited?  What is their view of the financial statements?  Is this good or bad? Be careful here – the auditors provide 2 reports – one on internal control and one on the financial statements.

Ernst & Young LLP. They have issued an unqualified opinion stating that the financial statements present fairly, in all material respects, the position of the company and its results from operations. This is good, if any other opinion is expressed – Reader beware!

8.      Note 11 explains the effective tax rates.  Does this alter how we should think about previous answers above?

In reviewing Limited’s tax note, we can see that the dramatic decline in the effective tax rate from ‘08 to ‘09 that we noted in Mini-Case 1 was largely due to a non-deductible impairment of Goodwill and other intangible assets in 2008 – which resulted in a much larger than normal effective tax rate of 51.9%. 

In 2009, Limited also benefited from a re-organization of its foreign subsidiaries which resulted in a 5% reduction in taxes - another one-time item. The 2010 effective tax rate, while close to the Federal statutory rate of 35%, includes a 2.4% reduction due to its divestiture of its remaining investment in Limited Stores (another item which will not persist).

So thinking about ROE or its components, in particular, profit margin – we should think about the impact of changing tax rates.  2008 NI was depressed due to a one-time tax increase – this decreases profit margin and ROE.  Conversely, other years have had positive effects.  Understanding sources of variation is important for forming expectations about future ROE and profitability.

9.      Evaluate the relative efficiency of Limited versus Chicos.  Justify your choice of tool(s).

From the Dupont analysis above, we saw that the turnover ratios were comparable.  We could further decompose that into inventory turnover, Fixed Asset (FA) turnover, etc.
The turnover ratios are the standard measure for efficiency.  Certain Industries also have specialized measures, for example in retail, sales per sq. ft. is important.


Limited
     2010

Inventory turnover
      5.78

FA turnover
      5.77

Total assets turnover
1.41


Chico's
            2010

Inventory turnover
               5.59


FA turnover

3.67

Total assets turnover
              1.39


In general, the ratios are comparable. Limited has improved inventory turnover for the period while Chico’s has remained unchanged. Limited seems to have an advantage when it comes to FA turnover. They generate more sales per dollar of fixed assets – indicating better efficiency or cheaper/less assets.  Limited has 5x the sales of Chico’s but only 3x the FA.

10.  Evaluate the Limited’s relative risk profile relative to Chico’s.  Justify your choice of tool(s).
Leverage
Chico's
Limited

2010
2009
2010
2009
Total Assets
         1,416
        1,319
        6,451
        7,173
SHE
     1,065
        982
    1,477
    2,184
Debt/Equity
33%
34%
336%
228%

The Dupont analysis told us that Limited was much more levered than Chico’s.
That analysis compared assets to equity.

Alternatively we can compare debt to equity. Here we use the broadest definition of debt – all non equity financing. The Debt/Equity for the Limited is higher.  Notice Debt = (Total Assets-SHE). 

Finally one can use coverage ratios to evaluate leverage.  Comparing operating income before interest to interest expense or CFO to interest payments – higher coverage implies lower risk and/or more debt capacity.  Note however, that Chico’s has no interest bearing debt and show interest income as opposed to expense – hence making a coverage ratio inapplicable.

The Limited has been in business much longer and therefore likely has a better reputation for stability among lenders – certainly its larger size is generally an advantage in borrowing as well.  Chico’s is a relatively new firm and is therefore more likely to have to rely on equity financing.  The nature of assets can also impact debt capacity; clearly leasehold improvements are not a great asset to lend against as they provide little resale value.  Limited’s Corporate Assets may be good collateral.
Leverage is a primary determinant of a company’s financial risk.  Of course, business risk is a key determinant to overall risk.  Given that the two firms are in the same industry, a key risk differentiator is financial risk.  Limited is slightly more risky given their higher leverage.


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